Extra Credit: Catastrophe Bonds - A Diversifier Like No Other

In this episode of Extra Credit, Andre Rzym and Tarek Abou Zeid discuss the world of catastrophe (cat) bonds. In 2023, insured losses from natural disasters stood at an estimated $3-5 billion, insufficient to worry the cat bond market but big enough to sustain demand for reinsurance. With low correlation to the major asset classes and higher yields than comparable securities, could this genuinely diversifying asset deserve a place in your portfolio?

Overview of this season of Long Story Short:

The world of credit is evolving. Gone are the days when investment grade bonds were only sold over the phone and the world of direct lending was a little-known niche. Corporates now have a multitude of ways to access capital and investors can diversify their credit allocation more than ever before. Extra Credit, the fourth season of our Long Story Short podcast, will explore the ways credit is changing and how it fits into your portfolio. Hosted by Danilo Rippa, Head of Global Credit Multi-Strategy and Global Convertibles at Man Solutions, this season will feature experts from across the credit investing spectrum.

Recording date: April 2024

Episode Transcript

Note: This transcription was generated using a combination of speech recognition software and human transcribers and may contain errors. As a part of this process, this transcript has also been edited for clarity.

Danilo

Welcome to Extra Credit, the latest season of our investment podcast. Long story short. Joining me today, Tarek Abou Zeid, partner and senior CPM at Man AHL and Andre Rzym, partner and portfolio manager at Man AHL. Thanks for joining us today. Let's dive into the fascinating world of catastrophe bonds, also known as CAT bonds. All I know is that they are fixed income instruments issued by insurers and reinsurers to help manage the risk of hurricanes and other disasters.

Danilo

Please tell us more. I mean, how do they actually work?

Andre

Danilo, thank you very much for inviting us today to your podcast. Maybe a good starting point would be to discuss why cat bonds exist at all, and to understand that you need to go back to the 1990s when you had large hurricanes such as Hurricane Andrew. In 92, you had Exxon, the Exxon Valdez oil spill and you had asbestosis claims, all of which were depleting insurance and reinsure capital and limiting their ability to write further business.

Andre

So cat bonds are a way of allowing insurers and reinsurers to access the capital markets to increase their capital base. The way that they work is that you have an SPV, which is used on the one side, a bond which an investor buys and the SPV faces. On the other side, the sponsor, the insurer or reinsurer who wants cover.

Andre

The sponsor pays a spread into the SPV. The proceeds from the purchase of the bond get put into an investment of some sort of high quality, and then the total ongoing return gets passed to the bond investor. So the risk free rates plus the spread and paid by the sponsor. Now, if there's no triggering event during the life of the bond, typically they're three years in maturity.

Andre

Then the proceeds get returned back to the investor and the investor is made whole. If there is a triggering event, then the proceeds are a cashed up and passed to the sponsor. So the sponsor gets cover for the event that was specified by the board by the cat bond. The important point here is that the investor has no credit risk, very little credit risk to the sponsor, and the sponsor has no credit exposure to the investor.

Tarek

You know, what the investors are facing. Effectively, these are floaters. So as an investor, by investing in a cat bond, you get risk free rate plus on top the spread of the peril where you are invested.

Danilo

Actually, I didn't know that the duration was so short it’s very interesting. You mentioned these are three typically three year bonds.

Andre

Exactly. So it's not just a three year insurance exposure, but from an interest rate exposure, it's negligible because of course, it's the assets are generating a floating rate return.

Danilo

Let me stop you there for a second. Can you explain to us what happens if the worst actually happens, how the mechanics work, but how often has this happened over the last few years? Which natural disasters have been most costly for the cat bond industry?

Andre

I think it's it's a bit misleading to almost pick a pick a bond and say this cost the bond space the most because the the market capitalization of cat bonds has been increasing steadily since 2001 to today when it's 40 billion. So it's not really comparing like with like.

Danilo

Is it a global asset class?

Andre

It is it covers global perils. So primary peril is the U.S. wind, US quake. But there are other perils such as its Italian quake, European wind, New Zealand quake and operational risk, terrorism risk and so on and so forth. So in terms of events which have been of interest to the space, you've got the likes of Katrina, Harvey, Irma and Maria, those are all $100 billion plus economic loss each events so very substantial.

Andre

If you look at the bonds which you've triggered over the years, it's not really a question of years of nothing happening. And then suddenly a bond triggers. There's a fairly steady rate of bonds being impacted and a year in which nothing was triggering would be quite unusual. I would say.

Danilo

When an event like this happens. What is historically been the recovery rate of these bonds? Do they get wiped out or there is enough diversification to have some recovery?

Andre

Well, each individual bond is linked to a specific peril. So it's not like, let's say, a general insurer where they have a diversified portfolio. You're buying into, you're writing a very specific perils in a specific geography and losses between a specific range. I would say the generally probably more often than not, recovery is low to zero, I would say.

Tarek

Now you're thinking about it from a individual bond perspective.

Danilo

Yes.

Tarek

And a different way to think about it, because this space to look at what is defined as a Swiss re bond index. So this is an index which is market cap weighted, encompassing multiple payrolls, and it's an investable, but nevertheless gives you an idea of the performance of the cat bond space, of course. And so you can look back historically at the largest events on Dimension Katrina memory years.

Tarek

A few examples. And if you look at the draw down of the index, in the worst market periods, you will see that the worst drawdown was -9% thereabouts.

Andre

So Ian was about -10%. Harvey led to a very short term spike of about 16% drawdown, but it settled within a week or two to something like six or 7% for the universe as a whole.

Danilo

Very, very interesting

Tarek

So the cat bond investor, you're really invested in the space and whilst you might have a default in your bond overall, the diversification of multiple perils, multiple geographies, make sure that your drawdowns are quite limited or have been historically quite limited.

Danilo

Okay. So can you explain why, despite a record number of billion dollar events in 2023, the cat bond industry did not incur any significant losses is for what is for the same reason.

Andre

It's maybe worth looking at. One of the parameters of the way that they describe particular bonds, and it's the distinction between per occurrence bonds and annual aggregate bonds. So a bond which is per occurrence, is triggered by single events whose losses exceed a certain amount. An annual aggregate bond is difference. What you do is that you add up all the qualifying losses throughout a one year period, and if that aggregate number of losses exceeds a certain amount, the bond triggers, otherwise it doesn't.

Andre

So they're really exposed to slightly different things. The per occurrence deals are exposed to single, very large events, whereas the aggregate bonds are more sensitive to a larger number of potentially less severe events. But still the aggregate bonds are including in the sum hurricanes, which are not just single billions, but tens and potentially hundreds of billions of dollars of loss.

Andre

So it's certainly true that last year we had a record number of billion dollar events, but still that wasn't enough to reach the threshold of even the aggregate ones because the number of hurricanes, while there was a large number last year, there was 19, which is the fourth highest on record. A few of them made landfall and none of them caused material insured losses.

Danilo

What's the split between these two structures? Annual aggregate in per occurrence?

Andre

It shifted somewhat over time, but it's something like 60% to 40%, I would say the market as a whole is maybe getting a little more concerned about larger number of somewhat smaller events and therefore things are more interest in the per occurrence. Bonds, I would say.

Danilo

And this takes me to the next question actually, what are the primary challenges in predicting the occurrence of natural catastrophes? How does the limited predictability of these events impact the function of the cat bond market?

Tarek

Maybe I should start with, you know, if you think about the largest battles, wind and quake, I start thinking about, you know, earthquakes. And if you look at, you know, USGS, which is one of the largest research effected federal agency focused on researching, looking at predictability of earthquakes. And and they publicly say that forecasting earthquakes is quite hard.

Tarek

It has you know, it's unachievable at the moment. And without a clear timeline on how this could be achieved going forward. and then you think about, you know, hurricanes and wind event and these kind of add to the unpredictability given, you know, wind events driven by multiple factors, you know, five days ahead of time.

 

Andre

I was going to change the subject slightly and maybe look at it from a different perspective. Imagine you're making a cake. How does it work? You mix the ingredients together, you put it in the oven and you get the cake back. And then if you. If you do the same thing tomorrow, you put approximately the same ingredients in your mixture.

Andre

The temperature is approximately the same, and the cake that you get out tastes approximately the same. But that that's called a stable system. But weather systems and natural natural systems in general are not stable systems. They're chaotic systems. And what that means is that very slightly different inputs or observe variables can lead to very different outcomes in the future.

Andre

And this was summarized by a mathematician and also a meteorologist called Edward Lorenz, who said Chaos is when the present determines the future. But the approximate presence doesn't approximately determine the future. And this is the problem that you face unless you know exactly everything about the climate system as it is now, it becomes increasingly difficult to forecast what's going to happen going forward.

Andre

So when you think about hurricane forecasts, you can look at how successful they are in the long term and in the short term. So some forecasters will produce, let's say, in December, a forecast for the activity in the following the following year. And if you look at those forecasts, the December forecasts, some of them are actually no better in predictive power than a simple average of what happened over the last few years.

Andre

And just assuming the same thing's going to happen this year. Now, when you come to look at short term forecasts, I'm thinking a five day ahead forecasts of a hurricane that's actually in the water, then Hurricane Dorian is a nice example here. This was a hurricane in 2019 where the five day I had forecast had it making landfall in Florida.

Andre

The cat bond market sold off. As a result, the hurricane actually never made landfall in Florida. The bond's back bounced back, not incidentally, before they traded along the way. So obviously there were some gains and losses by individual investors, but it just shows how difficult it is in the long term and in the short term to make forecasts of predictions of of what's going to happen.

Tarek

And just to add to this point, wind which which which is, you know, is one parallel in the carbon space. If you look at quake, if you look at the earthquake and ability to forecast earthquake, it's as difficult, even if not impossible at this time being to predict where that would happen, what kind of frequency you could have a long term rough idea, but over the short term, it's quasi impossible to forecast exactly the earthquake, the damage and the location.

Andre

You see as a consequence of this. I suppose in the way that bonds are issued, they come with what's called an expert analysis. There are a number, maybe four or five of modeling agencies who will look at the risks that the bond is exposed to, the perils, the geography, the seniority. And so on. And they'll come up with an analysis of the expected loss of these bonds.

Andre

These are largely actuarial in nature. They'll look at historic events and ask the question, would these trigger the bonds? And they have a catalog, if you like, of possible imagined events with imagined probabilities and ask the question, would these events trigger the bonds as well? So it's very much an actuarial way of looking at the exposures.

Danilo

Thank you for such a detailed answer. Before we move to the next question, I have a personal curiosity. What was the draw down of the bonds? And in the example you just described before they bounced back, you remember.

Andre

For the for the indexes on hold.

Danilo

For the index.

Andre

I suspect it was very modest.

Tarek

It's very modest. And even if you look at on a monthly basis, you wouldn't even see a drawdown.

Danilo

Okay. Interesting.

Andre

Bear in mind that there are hundreds of cat bonds outstanding and we're talking about two or three which are impacted. It was negligible for the Index. For the index as a whole. Yes. For the individual bonds, they were marked down and traded tens of points below par. So they were temporarily significant. The impacted, they then bounced.

Danilo

And do they trade when they are subject to drawdown events? Is there liquidity?

Andre

Liquidity is a relative concept. Cat bonds are trace eligible. So you can you can see historically the majority of trades that go through the markets. And in that particular case there were some trades and we looked at those particular trades and you could see the effects of the forecast almost certainly prompting the trading. And obviously you can see the subsequent bounce bounce back.

Danilo

Of course, to what extent do human activities influence the occurrence of natural catastrophes? For example, can you elaborate on the role of climate change in shaping the future of natural catastrophes and their impact on the overall carbon market?

Andre

Certainly, let's deal with some, non climate change examples first. Yes, if you think of fracking, for example, there's no documented case of fracking triggering a major earthquake. So we can put that one aside. There are specific legal framework issues in Florida surrounding what's called AOB assignment of benefits, which I would say distorts somewhat. The pricing of flow has distorted the pricing of Florida hurricane risk.

Andre

Then when you think about life and health, longevity has been impacted over recent years by a obesity and B, the opioid crisis and C, I suppose COVID as well. Then we move on to climate change, which is more the the elephant in the room. And the impact there fairly obviously depends on which panel you're talking about. It's if you're thinking about quake, the impact is negligible.

Andre

If you think about something like wildfire, well, there's a there's a very strong effect there and a consequence of an increasingly dry environment is is that the your distribution of historical losses is non stationary. So you can't really look back to the 1970s and use that as any sort of guide as to what's going to happen going forward.

Andre

You've only really got five years or something of relevance. Historical data with hurricanes, it's a slightly mixed picture picture. On the one hand you have warmer seas. We're expecting warmer sea surface temperatures and that is conducive to hurricane formation for hurricanes to strengthen. What you need is the air to be cycling up, cooling, going out, sinking, coming back into the center and forming a like a cycle.

Andre

Now, in order for that to to occur, you need relatively modest upper wind speeds in order that the the rising of air isn't being shear to one side. And there's some question over whether climate change will actually lead to increased wind shear, which would actually reduce the tendency of hurricanes to to intensify. Then, of course, you've got rising sea levels.

Andre

Well, if you've got higher sea levels, then your your vulnerability to flooding is obviously increased. And finally, there's a there's a sensitivity to actually hurricane horizontal motion. If the if hurricanes start to slow down in terms of their velocity, that's going to lead to greater, greater precipitation and greater flooding effects. That's all the bad news. The good news, to the extent that there is any, is that these bonds, as we mentioned, near the start of something like three years in maturity.

Andre

So your portfolio is one and a half years on average immaturity. So this gives the market time. As bonds mature, new bonds are issued to adapt to a changing environment, provided it's not happening sub three years in in horizon and it also gives the modeling agencies time to adapt their models to reflect a changing environment as well.

Danilo

And I guess as the asset class grows, there will be more opportunity for diversification.

Andre

That's the hope. It's certainly been the case over the years that U.S. wind and U.S. quake have been the primary perils and dominates the cap bond space. You do see from time to time some new peril. So, for example, New Zealand quake was it was a recent addition. But perhaps the more interesting one is cyber. So the first public cyber deals were launched last year.

Andre

There were four bonds in the last quarter of last year. And this is a space that I think there's opportunity for substantial growth.

Danilo

You mentioned at the beginning that the asset class is 40 billion. How long it's been 40 billion for how small was ten years ago or bigger?

Andre

Well, the markets pretty much began in 2001 in any sort of continuous sense. And roughly speaking, it's been growing. It's a couple of billion dollars a year. And what you see is firstly increased demand, if only because of asset inflation. And so you need to insure more expensive assets and also greater penetration of the insurance space by the cat bond markets.

Andre

And then the point that we were just talking about, namely new perils. And I think it's going to be the likes of cyber, which to the extent there's more than an incremental year on year couple of billion dollar growth, that's where the real growth is going to come from.

Tarek

And this is an important point to remember that we talked about the duration of these bonds being was the maturity of this bond being actually three years. So just to maintain the $40 billion we talked about, you have insurance officers every year on top of the new issuance, which would add to this market growth. So it's not just the 1.2 billion, it's 1.2 plus whatever needed to kind of keep up with the cap, with a market cap.

Danilo

But what are the main investors? How big do you think is going to be in ten years time? How do you think is going to look like from market participants and geographical distribution point of view?

Andre

Investors range from pension funds to hedge funds, and in fact, even reinsurers themselves invest in bonds because it can be a way of giving them diversification relative to their own portfolios. And there are some UCITS offerings out there. So there's actually penetration to to retail as well. And some of these funds are circa a couple of billion dollars, one and a half, $2 billion in size.

Danilo

I'm a credit allocator and I've been waiting to ask you this question from a portfolio construction point of view. Why invest in cat bonds? Why would investor consider cat bonds for their portfolios? Is it really just about diversification or is there more to it?

Tarek

What I mean, first and foremost, it's it's performance. So if you look at the long term performance of this on investible index we talked about earlier, you will see that the long term performance annualized return of somewhat about 7% with a volatility of three 4%. So as long as the performance is good, the short term performance could as well.

Danilo

Since inception.

Tarek

Since the inception of the index, if you look at we talked about drawdown. So the drawdown profile, the max drawdown on a monthly perspective was minus nine and the second worst drawdown was -6% or so. Again, on a monthly basis.

Danilo

Look, you remember the years when you have minus nine.

Tarek

Minus nine, must have been in 2021..

Andre

Minus nine would have been Hurricane Ian. And so that was 2000. In 22. And then the other one was 2000 and.

Tarek

17, I would say yes.

Danilo

So the minus nine in the 2022 context didn't look too bad with the traditional fixed income assets between -59 -25.

Tarek

So so this is just a long term performance. But you also have the short term performance, which last year again was very strong. So performance is one aspect.

Danilo

That can you remind us what is very strong from last year.

Tarek

Roughly around 20% was the performance of last year. Remember, you know, these bonds are floater. So you have the labor component and then you have the spread on top. Now, the second argument is diversification. I mean, effectively, you are putting in a new source of, you know, risk and return in your portfolio. You don't have, you know, credit risk, as I mentioned earlier, you don't have duration, let's say.

Tarek

And what you get is, again, a new source of diversification, which is of course not risk free, but is tied to natural catastrophes, is tied to events which are broadly different or orthogonal to what you would find in financial markets.

Danilo

Hey, not correlated to macroeconomic events.

Tarek

By large or not. I mean, liquidity might play an impact. If you have a large S&P selloff, you will see sell off everywhere. But it's broadly related to to go to to kind of the different type of 30 times. And the third point is really on social impact. These bonds effectively what you're doing is you are buying the risk that people would like to insure that houses the rooftops in Florida, earthquake damage and you are taking it put it on your book.

Tarek

So these bonds are could be considered as well as some sort of social bond with social impact.

Danilo

So they fare well from an ESG point of view. Is the correct.

Tarek

Correct. And even some bonds do use the proceeds of the bonds instead of putting them in labor, but to put them to work in projects and in sustainable projects as defined by the IMF and various resources.

Andre

Yes. I mean, just just to extend on that points, some bonds might be linked to, for example, the government of Mexico providing them with a payout in the event of a quake or a hurricane. And it is designed specifically to try and decouple the finances of the states from from natural catastrophes and tariffs points about the use of proceeds.

Andre

We talked right at the beginning about an SPV issuing these bonds sometime times bonds are linked or issued directly off the balance sheets, and then the proceeds of the bonds are on segregated, but they're rather used by the RBI day for sustainable development projects. So you sort of have this double whammy of providing a benefit to a sovereign.

Andre

Yeah, And along the way the cash is being put to good use. Just going back to tax points about reward and correlation, I'm more I get more excited about the correlation than I do about return. I mean don't get me wrong returns. Nice. But when you think about the correlation...

Danilo

Mean lack of correlation.

Andre

The lack of correlation, when you think about the correlation to equities and bonds, depending on which period you're looking at, it'll be something like plus or minus point. So but I think more interesting is the tail behavior. And it's not just that the the bigger drawdowns in the cap bond space happen independently of big drawdowns in the financial markets.

Andre

But it's that you can you can understand why that's the case and you can understand why going forward that's likely to continue to be the case. They simply completely different risks. So it's not by chance that the losses occurred at different times. There was never any reason why they should occur together.

Danilo

It sounds to me like it is a fraction of what it should be, because it's compelling for the issues is very compelling for the investors.

Andre

I agree. I mean, it's possible that the word cat that frightens people. Cats are nice, fluffy animals, but catastrophes maybe not so much.

Tarek

I mean, keep in mind that it's a fairly recent, nascent asset class. It and, you know, the beginning and I mentioned what on the back of of of large events in the 19 1980s 1990s and so it's it's a developing asset class and you see the growth in the from zero to around $40 billion a day.

Danilo

Let me ask you a final question to summarize and also help our audience, what strategies would you recommend for investors looking to navigate the CAT bond market effective to summarize and also help our audience, what strategies would you recommend for investors looking to navigate the CAT bond market effectively?

Tarek

Let me give my take and then leave it to Andre for final words. I mean, we are in no position to give advice to clients on on on on strategies and funds, and we can only talk about in our approach and as we talked and elaborated on, predicting natural catastrophes is inherently hot. And if we're not able to predict natural catastrophes, what you're left with is portfolio construction.

Tarek

And if you left portfolio construction, what you can do and what, you know, systematic player could do is to build a portfolio which is robust, looking at splitting risk across multiple battles and making sure that you don't have concentration in your portfolio.

Andre

Andre I completely agree. To me, this is an exercise in robust portfolio construction in balancing the fact that certain perils think of Florida wind pay better per unit of risk and therefore all things being equal, you might like to be more concentrated there, but balancing that against the need for diversification. The other thing I would say is that, yes, this is a these are public bonds, that they're tradable.

Andre

They do trade. They trade regularly. But the bid offers we're not talking about the US Treasury markets here, and therefore, we tend to think more in terms of buying with a view to holding for the long term rather than buying for short term opportunities. It comes back to the idea of us not even seeing short term alpha, but even if you did, this is a relatively expensive space in which to train and realize those gains.

Danilo

So is it's mainly about portfolio construction at inception rather than precisely trade. I'm sorry. Interesting. Thank you for joining us, Tarek and Andre, It's been great to have you here.

Tarek

It's a pleasure. Thank you.

Andre

Thank you very much.